Penn effect

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The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exaggerated by GDP conversion at market exchange rates. It has been a consistent econometric result for at least fifty years.

The "Balassa-Samuelson effect" is a model cited as the principal cause of the Penn effect by neo-classical economics, as well as being a synonym of "Penn effect".

Contents 1 History 2 Understanding the Penn effect 2.1 The effect's challenge to simple open economy models 2.2 How identical products can be sold at consistently different prices in different places 2.3 The price level 3 The international development implications 4 See also 5 External links 6 References 7 Footnotes

[edit] History

Classical economics made simple predictions about exchange rates; it was said that a basket of goods would cost roughly the same amount everywhere in the world, when paid for in some common currency (like gold)¹. This is called the purchasing power parity (PPP) hypothesis, also expressed as saying that the real exchange rate (RER) between goods in various countries should be close to one. Fluctuations over time were expected by this theory but were predicted to be small and non-systematic.

Pre-1940, the PPP hypothesis found econometric support, but some time after the second world war the pattern changed, and the Penn study was the first to identify a modern trend; countries with higher incomes consistently had higher prices (as measured by comparable price indices).

In 1964 the modern theoretical interpretation was set down as the Balassa-Samuelson effect, with studies since then consistently confirming the original Penn effect. However, subsequent analysis has provided many other mechanisms through which the Penn effect can arise, and historical cases where it is expected, but not found. Up until 1994 the PPP-deviation tended to be known as the "Balassa-Samuelson effect", but in his review of progress "Facets of Balassa-Samuelson Thirty Years Later" Paul Samuelson acknowledged the debt that his theory owed to the ICP/PWT data-gatherers, by coining the term "Penn effect" to describe the "basic fact" they uncovered, when he wrote:

"The Penn effect is an important phenomenon of actual history, but not an inevitable fact of life."

[edit] Understanding the Penn effect

Most things are cheaper in poor (low income) countries than in rich ones. Someone from a "first world" country on vacation in a "third world" country will usually find their money going a lot further abroad than at home.

For instance, the same Big Mac cost $5.46 in Switzerland, and $1.49 in Russia in December 2004, at the prevailing USD exchange rate into the local currencies. To avoid confusion arising from money prices the nominal exchange rates are usually ignored, with only the 'real exchange rate' (RER) being considered. (Here, 3.66 Russian meals to one Swiss.)

[edit] The effect's challenge to simple open economy models

The (naïve form of the) purchasing power parity hypothesis argues that the Balassa-Samuelson effect shouldn't occur. A simple economic model treating Big Macs as commodity goods implies that international price competition will force Swiss, Russian, and U.S. burger prices to converge in price. The Penn effect denies this convergence; it is clear evidence that the general price level is much higher where (dollar) incomes are high, with no tendency to match the cheaper prices in poorer countries.

[edit] How identical products can be sold at consistently different prices in different places

The law of one price says that the same item cannot sustain two different sale prices in the same market (since everyone would buy only at the lower price). By reversing this law, we can infer that different countries do not share an efficient common market from the fact that prices for the same good are different.

If a McDonalds patron in Zurich were able to eat in an identical Moscow restaurant at quarter the price she would do so, and price competition would then equalize the Big Mac price throughout the world. Of course, someone can only eat out locally, so regional price differentials can persist; the Moscow and Zurich branches are not in competition. If the Moscow McDonalds starts giving away burgers the price in Zurich will be unaffected, since one is unlikely to dine in Moscow if starting the evening in Zurich (especially if dining at McDonalds).

[edit] The price level

Measuring 'the' price level involves looking at goods other than burgers, but most goods in a price index (CPI) show the same pattern; equivalent things tend to cost more in high income countries. Most services, perishable goods like the Big Mac, and housing cannot be purchased very far from the point of consumption (where the consumer happens to live). These items form the typical consumer shopping list, and therefore the CPI level can vary from country to country, just like the burger price.

[edit] The international development implications

The PPP-deviation allows rural Indians to survive on an income below the absolute subsistence level in the rich world. If the money income levels are taken as given, then ceteris paribus, the Penn effect is a very good thing. If it did not apply, millions of the world's poorest people would find that their income was below the survival threshold. However, the effect implies that the money income level disparity as measured by international exchange rates is an illusion, because these exchange rates only apply to traded goods, a small proportion of consumption.

If the genuine income differential (taking local prices into account) is exaggerated by the RER, so the real difference in the standard of living between rich and poor countries is less than GDP per capita figures would suggest. To make a more significant comparison, economists divide a country's average income by its CPI.

[edit] See also

• The Economist's Big Mac Index consistently shows four-fold differentials in the burger's price.
• Purchasing Power Parity is the situation in which RERs are 1, a nil Penn effect.

[edit] External links

• 2004 Econometric study of the effect's: rise since circa 1950 (their time series starts 1500 AD, with the Penn effect only noticeable 450 years into the data). The appendix contains a thorough (eight page) two country General equilibrium derivation of the effect's size based on the BS-hypothesis across a continuum of industries, endogenously split between traded and non-traded production. However, the paper as a whole is focused on analysis of historical economic data.
• G-20 ICP: An analysis of the data in the International Comparison Program gives clear Penn effect examples
• Long Run Purchasing Power Parity: Cassel or Balassa-Samuelson? - A direct 2003 comparison of Cassel's pure PPP-hypothesis and the Penn effect deviation at scales estimated by the BS-hypothesis (using data from sixteen industrialized countries). Surprisingly, this University of Houston study finds that industrialized countries tend to fit Cassel's hypothesis better (at a ratio of 2 countries to 1). This result can occur (despite an apparently clear correlation of income to price) because of the long reversion times expected by the PPP hypothesis.
• [1] TravelXL 2005 price level index for food and lodging around the world

[edit] References

• Samuelson, Paul A. 1994, Facets of Balassa-Samuelson Thirty Years Later, Review of International Economics 2 (October 1994 special edition has several papers discussing the effect). Abstract defining the Penn effect term.

[edit] Footnotes

¹ For instance, economists in 1949 expected that one could buy similar quantities of meat in New York for one dollar as in Tokyo for 360 Yen, the pegged nominal exchange rate at the time. It was thought that deviations from this would mostly be caused by problems of supply, and the fact that exchange rates were not allowed to float to market levels by most of the world's central banks (before the 1970s and the end of the Bretton Woods era of gold convertibility).